Hedging – Indian stock market context

Contributed by: Meera Siva, CFA

PR Sundar is not a conventional speaker and a standard blog will not do. At the CFA Society Chennai Chapter’s speaker event on January 4, 2019 (GRT Grand Hotel), he spoke on option strategies. While the topic tends to be often Greek, he simplified with analogies, examples and peppered it with a lively humour and stats (did you know that the South Korea’s index is the most traded index option contract in the world?) which kept the packed crowd (44, with a few coming from out of town to attend) completely engaged. Sample this. He asked what a hedge was; then searched Google; it showed pictures of plants – hedges which act as fences to protect.

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As a TV celebrity trader who is well covered in the print media and a strong social media following, PR Sundar needs no introduction. In a segment where professionals get wiped out, he is clocking gains year after year. A maths teacher in his early years and coming from a rural background, he is self-taught; his knowledge and success are thanks to his passion and poise.

The trader

As strategies must gel with the nature of the person implementing it, he took nearly a third of his 100-minute talk to share his background. It helped the listeners evaluate if a strategy would be suitable for them or not.
For example, he explained how he had little or no knowledge of the stock market and briefly subscribed to IPOs as a low risk strategy (pre Harshad Mehta days). And got back to the market quite by chance and how his value system has been built. He noted that people (through the example of his class-mate) do not take risks when they have the ability (capital, stable cashflow) but want to do it when they don’t (no income and limited savings).

Why sell options?

Sundar views selling options akin to selling insurance. There is a lot of mainstream media narrative that buying options is low risk and high reward while selling options has unlimited risk. He, however, uses option selling to enhance returns of a buy-and-hold investor’s portfolio. “Holding gives price-value to an investor while options give time-value gains”, says Sundar.

To illustrate, he shared returns of an investor’s portfolio of about INR 6.5 crores since late October 2018. Capital appreciation of the portfolio was about INR 65 lakhs in 2 months. On a hedged portfolio of INR 4.2 crores, option return was INR 73 lakhs in the same period.

The strategy is to have an underlying and selling options backed by it. The reason it works is that stock prices do not change in either direction very fast and stays around the same levels. So, selling options gives cashflow. For instance, if a stock trades at INR 900, you can sell call options for INR 1,000. If the stock does not move, call option sale gave you some return. If it moves by less than INR 100 before the option expired, there is call sale plus capital appreciation. If it crosses INR 1,000, you can deliver the stocks when the option is called; there is call sale gain plus the INR 100 from stock price increase.
For many stocks, there is no issue of liquidity. But if the volumes are low, it is best to use an index as a proxy (NIFTY or sector NIFTY).

Some strategies
Martingale Strategy: Consider a stock at INR 1,100. Call options @ INR 1,200 may be priced at INR 10 and you can sell these. If prices shot up fast, to INR 1,200, you can offset it by buying 1,200 calls. They may be priced at INR 15 now. To fund this, sell options at 1,250. These may be priced at say INR 7.5, so you may have to sell twice as many as the 1,200 calls. You can keep repeating this strategy of doubling. You will not have the underlying to deliver as you go on this route and must manage your margin. The good thing is that the underlying’s price is increasing, giving you some cushion.

Collar strategies: A collar strategy involves selling calls at a higher price and buying puts at a price lower than current price of underlying. This limits the risk and return in a range (or collar), for no cost. In this, if the number of calls you sell is double that of the puts, there is a gain. Here again, if the market runs up, you can do the Martingale strategy to extend your runway.

Ratio spread: The idea of this strategy is to keep the upside (by taking some risk) while limiting the downside. If the market has support at say 10,000 levels, you can buy puts for 10,800 and sell double the quantity of 10,000 puts. The prices of these two may offset each other. If the market goes up, you capture the upside. If it does down, there would be losses and other strategies must be used to manage the situation (as the original assumption of support at 10,000 levels did not pan out).

There are many other strategies beyond this. For example, there are methods to deal with binary events such as the Parliament elections.

The talk gave a glimpse of how calls and puts, buying and selling, numbers and price, can be used based on the market view. Not just that, you must closely follow the action and tactically adjust your position based on the market movement – or changing the dance to the tune of the market, as Sundar says.

-MS

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